How Unexpected Trends Are Shaping Private Equity Strategies

Interest rates are crucial in shaping the landscape of private equity transactions. Lower rates make borrowing cheaper, which ultimately boosts real estate valuations, and makes LBOs of asset-intensive businesses more appealing. On the flip side, higher rates can slow activity down. Despite hopes for rate cuts to combat economic slowdowns and spur investment, the Federal Reserve has kept rates steady thus far in 2024. This has forced private equity firms to rethink their strategies.

Interest Rate Expectations vs. Reality

Coming into 2024, most people expected the United States Federal Reserve to cut rates, driven by economic uncertainties and a general slowdown. However, inflation pressures and a strong labor market have led the Fed to hold rates steady. Even with April's inflation report showing a smaller-than-expected rise in consumer prices, brokerages are still expecting a rate cut around September. This has left private equity firms, which were gearing up for cheaper capital, in a bit of a bind.

Below is a snippet illustrating how brokerages' forecasts for rate cuts in 2024 have changed from before the March CPI data to after the April CPI data. The discrepancy in rate cut expectations is even wider when looking back to the fourth quarter of 2023.

Impact on Deal Volumes and Valuations

Private equity deals typically slow down when interest rates are high and volatile. Higher borrowing costs make leveraged buyouts and debt-financed deals more expensive and therefore less attractive. This also impacts valuations as buyers have difficulty accessing acquisition financing. In 2024, the lack of expected rate cuts has resulted in a noticeable slowdown in deal volume. In fact, on the contrary, interest rates have actually increased since the start of 2024 and expectations have shifted to their stabilizing over the remainder of the year before any cuts occur. Firms are being more cautious and scrutinizing potential acquisitions more closely because of the higher cost of debt, and dealflow has remained somewhat consistent with 2023’s decline in activity, where global deal volume declined 47 percent to a 10 year low of $650 billion.

Valuations have taken a hit too. More expensive borrowing means PE firms are using higher IRR thresholds to evaluate deals. This has led to more conservative valuations, with firms less willing to pay premiums. As a result, some sellers are holding off on transactions, waiting for a better interest rate environment. According to KPMG’s 2024 M&A outlook, 66% of PE respondents said that rate cuts will need to occur before M&A activity can return to previous peak levels.

Leverage and Financing

Leverage is crucial in private equity deals. Higher interest rates mean higher debt service costs, which affects the leverage ratios firms can handle and prices that acquirers can pay. In 2024, PE firms are facing tighter lending conditions and higher interest expenses, making highly leveraged deals less appealing.

Lenders are also being more selective and demanding stricter terms. This tightening of credit conditions has led to more stringent financing terms, affecting both the size and structure of deals.

Increased Use of Sale Leaseback Transactions

A notable trend in response to the current interest rate environment is the increased use of sale leaseback transactions. Chelsea Mandel, our Founder and Managing Director at Ascension Advisory, notes that many private equity firms and financial sponsors are turning to sale leasebacks for the first time to execute deals despite high interest rates, and often as a result of less accessible traditional financing.

Mandel commented: “Many of our clients over the last 24 months are either private equity firms or other types of financial sponsors (independent sponsors, search funds, etc.) that we have not worked with before, as they have not done sale leasebacks in the past. Many groups have turned to sale leasebacks as a more mainstream source of financing for their portfolio companies especially as interest rates on other forms of traditional debt have shot up dramatically over the last couple years.” Furthermore, over the past 24 months, nearly 30% of our sale leaseback closings were transactions where the sale leaseback proceeds were used to finance M&A. The sale leaseback strategy is definitely gaining traction as a mainstream financing option.

Strategic Adjustments

In response to steady interest rates, private equity firms are adjusting their strategies

1. Operational Improvements: Firms are focusing more on driving value through operational enhancements rather than through financial engineering. This includes boosting revenues through digital transformation, expanding into new markets, and enhancing customer experiences, improving efficiency through process automation, cost management strategies, and lean manufacturing techniques, and optimizing supply chains within portfolio companies.
   
   
2. Add-On Acquisitions: Faced with tougher exit conditions and scarce affordable debt, PE firms are increasingly using add-ons—smaller acquisitions made by existing portfolio companies—to deploy capital and maintain valuations.
   
   
3. Sectoral Shifts: Some private equity firms are shifting towards sectors less sensitive to interest rate changes, like technology and healthcare, which offer growth opportunities independent of borrowing costs.
   
   
4. Alternative Financing: Innovative financing solutions, such as private credit and mezzanine financing, are becoming more popular as firms look to bridge the gap left by traditional lenders.

Future of Sale Leaseback Transactions

We anticipate that the volume of sale leaseback transactions will remain high even if interest rates begin to fall. As borrowing costs for investors become cheaper, cap rates will likely follow, allowing sale leaseback investors to pay lower cap rates, leading to higher valuations and more deal activity. Additionally, firms that turned to sale leasebacks during high-interest times are likely to keep using this strategy now that they’re familiar with it, even when other financing options become more accessible.

Conclusion

The Federal Reserve's decision to maintain interest rates in 2024, contrary to widespread expectations of rate cuts, has had significant implications for the private equity sector. Deal volumes have slowed, valuations are more conservative, and leverage levels have decreased. However, these challenges are driving strategic adaptations, including the increased use of sale leaseback transactions, which may lead to more robust and resilient investment practices. As the year progresses, private equity firms will need to navigate this environment strategically, balancing caution with the pursuit of new opportunities.